Overhead 4 Introduction to Open Economy Macro

Page 1: Introduction to Open Economy

Lukas Mayr presents the concepts regarding an open economy.
Focuses on macroeconomic principles and frameworks regarding international interactions.

Closed Economy:
- All output produced is consumed and invested domestically.
- National accounting identity:
  - Equation: 𝑌 = 𝐶 + 𝐼 + 𝐺
    - Where:
      - 𝑌 = National output
      - 𝐶 = Consumption
      - 𝐼 = Investment
      - 𝐺 = Government spending
Open Economy:
- Introduces transactions with foreign economies:
  - Equation:
  - 𝑌 = 𝐶 + 𝐼 + 𝐺 + 𝑋 − 𝑀
    - Where:
      - 𝑋 = Exports
      - 𝑀 = Imports
Trade Balance:
- Defined as net exports:
  - Equation: 𝑁𝑆 = 𝑋 − 𝑀
- Scenarios:
  - Trade Surplus: 𝑁𝑆 > 0 (𝑋 > 𝑀)
    - Economy spends less than it produces.
  - Trade Deficit: 𝑁𝑆 < 0 (𝑋 < 𝑀)
    - Economy spends more than it produces.
- Domestic Spending vs. Output:
  - Equation: 𝑁𝑆 = 𝑌 − (𝐶 + 𝐼 + 𝐺)
  - Implies domestic spending greater than output leads to negative net exports.

Closed Economy Dynamics:
- Savers lend to domestic borrowers only.
- Investment financing limited to domestic resources.
  - Savings equals investment:
  - Equation: 𝑆 = 𝐼
Open Economy Dynamics:
- Savings can finance both domestic and foreign investment.
- International Capital Flows:
  - Capital can flow abroad or return back to finance foreign assets.
- Foreign Investment Types:
  - Financial Assets: Stocks, bonds.
  - Physical Assets: Ownership of factories, offices.

Net Capital Outflow (NCO):
- Equation: 𝑁𝐶𝑂 = 𝑆 − 𝐼
- Scenarios:
  - If 𝑆 > 𝐼: Net lender (excess funds flow abroad).
  - If 𝑆 < 𝐼: Net borrower (firms borrow internationally).
Linking Capital Outflow and Trade Balance:
- Equation: 𝑌 − 𝐶 + 𝐺 = 𝑆 = 𝐼 + 𝑁𝑆
- Therefore, 𝑆 − 𝐼 = 𝑁𝑆
- Persistent trade deficits imply lower savings relative to investment (Example: U.S. is a net borrower).

Figure 1: Comparison of saving-investment balance and current accounts in China and the U.S.
Trend analysis from 1995-2007 shows fluctuations in net savings and current accounts between two nations.

Definition: Records all transactions between a country and the rest of the world.
Components:
- Current Account:
  - Records exports/imports of goods and services
    - Includes:
      - Net exports
      - Net factor payments
      - Transfer payments
- Financial Account:
  - Records:
    - Purchases and sales of foreign/domestic assets
    - Transactions impact on financial flows.

UK Current Account Components Overview:
- Graph depicting trends from 1987 to 2016 in the UK financial account elements.
Key Components:
- Direct Investment:
- Trade:
- Income:
- Transfers:
- Visual fluctuations highlight economic interactions over time.

Definition: Price of one currency in terms of another.
Exchange Rate Methods:
- Price of domestic currency in foreign currency.
- Price of foreign currency in domestic currency.
- Examples given for practical understanding.

Graph showcasing fluctuations in nominal exchange rates from 2000 to 2016 across several currencies highlighting economic impacts during the period.

Definition: Relative price of domestic goods in terms of foreign goods.
Equation for Real Exchange Rate (𝜖):
- 𝜖 = 𝑒 𝑃 / 𝑃∗
Variables:
- 𝑒 = Nominal exchange rate
- 𝑃 = Home price level
- 𝑃∗ = Foreign price level.

Assumptions: No transportation costs or trade barriers can lead to price equality.
Concept: Same good in different countries must have the same price in a common currency.
Arbitrage Opportunities: Price differences lead to profits as goods are sold from low to high-priced markets, correcting the price inequality.

International Context: Same good across countries must hold price equality when expressed in common currency.
Purchasing Power Parity (PPP):
- Equation: 𝑒 = 𝑃 / 𝑃∗
- Ratio of price levels determines nominal exchange rates.
- Potential for arbitrage remains unless equilibrium holds.

Real World Limitations:
- Not all goods can be traded.
- Transportation costs affect pricing.
- Goods from different markets can be imperfect substitutes.

Referenced materials cover trade balance correlation with exchange rate variances.
Covered and Uncovered Interest Parity: Further details discussed on projections.